Supreme Court Decision on Bankruptcy Code Section 546(e) Significantly Expands the Risk of Fraudulent Transfer Liability in Failed M&A transactionsMarch 2018
In Merit Management Group, LP v FTI Consulting, Inc.1, the Supreme Court held that section 546(e) of the Bankruptcy Code does not limit a trustee’s ability to recover on avoidance claims even though the payment or transfer path is effected through financial institutions as conduits.
The unanimous decision resolved a split in the U.S. Courts of Appeals in which a majority of the circuits held that such transfers were immunized from recovery. Rather, the Supreme Court held that section 546(e) does not protect the “overarching transfer” to the ultimate beneficiary of the transfer from or on behalf of the debtor. Because a majority of the circuit courts held to the contrary, this is an important ruling that significantly expands the risk of fraudulent transfer liability in connection with failed M&A transactions, which were the facts present in Merit.
Merit arose from the merger of Valley View Downs, LP (“Valley View”) and Bedford Downs Management Corporation (“Bedford Downs”), both of which had competed for the last available harness racing license in Pennsylvania. When each of their separate efforts to obtain the license were unsuccessful, they determined to merge, make another attempt to obtain the license and operate as a “racino.” In the merger, Valley View was the surviving entity and was to purchase all of the stock of Bedford Downs for $55 million. Valley View hired Credit Suisse to help finance the transaction and Citizens Bank of Pennsylvania (“Citizens Bank”) acted as the escrow and paying agent. To close the merger, Credit Suisse wired the funds to be used to pay Bedford Downs stockholders to Citizens Bank. Merit Management Corp. (“Merit”), a Bedford Downs stockholder, received approximately $16.5 million in connection with the merger from Citizens Bank.
Valley View was unsuccessful in opening a racino and later commenced a chapter 11 proceeding in which a plan of reorganization was confirmed. The plan provided for the establishment of a litigation trust for the benefit of Valley View creditors, and FTI Consulting, Inc. (“FTI”) was appointed as the litigation trustee. In 2015, FTI brought a fraudulent conveyance action against Merit seeking recovery of the $16.5 million it had received. Merit moved for judgment on the pleadings, arguing that the payments it had received were protected by the safe harbor of section 546(e) of the Bankruptcy Code because it was (1) a “settlement payment” or a payment “in connection with a securities transaction” and (2) was made “by or to (or for the benefit of )” covered financial institutions, specifically Credit Suisse and Citizens Bank.
The District Court granted Merit’s motion, but the Seventh Circuit reversed. The Supreme Court granted certiorari to resolve a split in which the Second, Third, Sixth and Tenth Circuits had ruled that section 546(e) immunized such payments, while the Seventh and Eleventh Circuits had rejected such protection.
The positions of the parties in the Supreme Court litigation were clear: Merit contended that the Court was to consider not only the Valley View-to-Merit transfer, but also the underlying Credit Suisse-to-Citizens Bank, and Citizens Bank-to-Merit transfers. Merit argued that because those components included transactions by and to financial institutions, 546(e) barred recovery from it.
FTI argued that the Court should focus on the overarching transfer from Valley View to Merit, and that because that transfer did not involve a financial institution on either end, section 546(e) did not apply or prohibit a recovery.
The Court began its analysis by examining the text of section 546(e), which provides:
Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment, as defined in section 101, 741, or 761 of this title, or settlement payment, as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract, as defined in section 741(7), commodity contract, as defined in section 761(4), or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A) of this title.
The Court said that in interpreting the statute, “the focus of the inquiry is the transfer that the trustee seeks to avoid,” which was the transfer from Valley View to Merit, and held that “Congress signaled that the exception applies to the overarching transfer….not any component part of that transfer.” Thus, because the “overarching transfer” was between Valley View and Merit, neither one of which was a covered financial institution of the type identified in 546(e), the limitation on avoiding powers did not apply.
Merit argued that any transaction by or to a qualifying financial institution was covered by section 546(e), regardless of whether the financial institution had a beneficial interest in the transfer. It argued that in amending section 546(e), Congress had meant to overrule the decision in In re Munford, Inc.2, which ruled that section 546(e) did not immunize an otherwise avoidable transaction even though it had been effected through financial institutions. Merit also argued that the purpose to section 546(e) was to immunize, to the greatest extent possible, transactions effected through financial institutions for the purpose of protecting finality in transactions involving the public securities markets.
But the Court rejected all of Merit’s arguments, finding that both the text of the statute and public policy supported limiting the 546(e) exception to payments to financial institutions, not the overarching transfer from the initial payor, Valley View, to the ultimate beneficiary, Merit.
The Court’s unanimous decision in Merit limits the scope of section 546(e) and thus opens the possibility for trustees to seek to recover payments to shareholders in failed M&A transactions. Valley View is not the first M&A transaction to fail, nor will it be the last. Until the Court decided Merit, many participants and advisors in mergers transactions, particularly those involving public companies, believed that section 546(e) protected cash-out payments made through financial intermediaries. And although Merit had argued in favor of protecting the finality of such payments, the Court’s opinion showed no sympathy for that argument. Merit thus becomes a new tool for trustees to consider in failed M&A transactions.
 283 U.S. _____ (2018), 2018 WL 1054879 (Feb. 27, 2018).
 98 F.3d 604 (11th Cir. 1996).
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